While it was once considered unacceptable to not be able to pay bills, debt has become commonplace in the United States. The vast amount of companies that exist here are no exception to this. In order to make money, they often have to keep a high level of debt on their books. Some of them are those who have heard of the debt service coverage ratio.
Hopefully, in a good fiscal period, it doesn’t exceed what they are going to be able to pay back. Because if it does, they can be in serious financial trouble. But the only way for them to know is to keep tabs on the amount of debt that they have in comparison with their income. This is done using the financial equation called debt service coverage ratio.
What Is a Debt Service Coverage Ratio?
The debt service coverage ratio is a representation of the ability of a company to pay off their debts in entirety at any given time.
- It is calculated by first determining what the net operating income is. This appears by adding together the net income with any amortization, depreciation, and interest. Sometimes, companies can liquefy assets that can quickly for cash and include them, but it is not always possible.
- Next, the principal and interest payments on any loans or debts that are due add together. Long-term lease payments also should be part of this. They are mandatory if there is a set legal obligation that requires them to be paid for an extended period of time. The total of all of these obligations equates to the debt service that the company owes.
- The last step in the calculation is to divide the net operating income by the amount of the debt service obligations. If a company is in good financial shape, the number should be about 1.2. That means, at any given time, they can pay off their debts completely. Also, they will still have income leftover for the company to function on. It is not uncommon for a company to have a ratio slightly lower than this though. But the further that it falls, the less likely that they are to be able to qualify for a loan from a bank.
Debt service coverage ratio = Net Operating Income / Annual Debt Service.
Who Needs to Use a Debt Service Coverage Ratio the Most?
Companies who are looking for investors have to be able to represent themselves as being a solid, stable financial investment that has the potential for growth and profit. So both public and privately traded companies watch this ratio closely. And, as mentioned before, those who wish to apply for loans will need it too. Most banks won’t approve loans for a company that has less than a 1.2 debt service coverage ratio. This is because they have a higher chance of defaulting on them.
However, more aggressive national banks sometimes approve them, but they charge a higher interest rate on the loans. This means that the new debt will make the debt service coverage ratio even lower than it was before for those who have no choice but to take them.
How Much Is Spent on Achieving This Ratio?
It takes a skilled financial professional to be able to do a lot of the calculations necessary for achieving this ratio. That is because the numbers have to be pulled off of complicated financial documents that an untrained person won’t understand.
So, most companies have to hire an accountant to get an accurate number. But still, it takes several hours of work to make sure that everything is correct. This can cost hundreds of dollars per hour if the professional that is hired is a certified public accountant or financial adviser.
3 Ways to Reduce Costs of the Debt Service Coverage Ratio
Companies who are already strapped for cash will be happy to know that there are some cost-saving methods that you can use to decrease the price that they have to pay for getting their debt service coverage ratio. Three of them include:
- Staying on top of financial records is key to saving money. This reduces the amount of work that an accountant has to do. Track all amortization schedules and loans regularly. Also, be sure to reconcile them with the bank statements or leaseholder sheets to ensure that they are always accurate. Being off by even a few dollars can cause hours of back-tracking that can be very costly in the long-run.
- Companies which do some of the work themselves can also reduce the amount of time that it takes to get this ratio. For example, they might print out all of the financial statements to give to the accountant. Also, they can add up some of the numbers that they know are correct.
- Negotiating the price to do the work is sometimes possible too. Accountants are often willing to do work for a cheaper rate during times of the year that they are not busy with preparing taxes. So, companies that are willing to wait a little longer to get their debt service coverage ratio usually pay less.
To Sum It Up
The debt service coverage ratio is an important calculation for all companies to know. It is a representation of their financial health. A ratio of over 1.2 is best. But sometimes, companies have a ratio of less than this. The lower the number is, the less likely that a company has a chance at getting a loan or solid investor backing that they need.
Since achieving this calculation is a little complicated, we recommend you to keep this information handy for later use. Also, feel free to share it with other professionals who could benefit from it as well. If you have any comments or information regarding this topic that you would like to share, comment below. We would love to hear from you!
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